Discussion Paper

Industrial organization is mainly concerned with the behavior of large firms, especially when it comes to oligopoly theory. Experimental industrial organization therefore faces a problem: How can firms be brought into the laboratory? The main approach relies on framing: Call individuals “firms”! This experimental approach is not in line with modern industrial organization, according to which a firm’s market behavior is also determined by its organizational structure. In this paper, a Stackelberg experiment is considered in order to answer the question whether framing individual decision making as organizational decision making or implementing an organizational structure is more effective in generating profit-maximizing behavior. Firms are either represented by individuals or by teams. Teams are organized according to Alchian and Demsetz’s (1972) contractual view of the firm. I find that teams’ quantity choices are more in line with the assumption of profit maximization than individuals’ choices. Compared to individuals, teams appear to be less inequality averse.

Comments and Questions

Joshua Konov
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The Rule of Law in Business should apply to Corporate Decision Makers

October 24, 2012 - 12:07

If corporations are considered as individuals with a group liability the decision makers could easily get away with international crime, whereas cases as kiobel v. shell supreme court case would become perpetual, occasionally politically motivated. Therefore, corporate limited liability should change into unlimited such specifically for the corporate decision-makers:
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The Rule of Law in Business

From generations the rule of common law does not apply to business in its force and clarity because it is considered counterproductive in providing most adequate conditions for businesses to grow up. Business environment should be foggy and deregulated for economy to prosper was considered. Unless in the Common Law where clarity was main priority in Business Law the opportunism was its main priority.

The ideas about the role of “the rule of law” differ:

“Not surprising, people disagree a great deal about how many laws (and what sort of laws) are just right. For example, liberals tend to think we need lots of laws to control corporations, to protect minorities, to protect the environment and to provide social goods. As another example, while American conservatives claim they are for “small government”, they tend to want more laws limiting things such as sex, drugs, and various personal liberties they disagree with. This nicely matches the fact that the guiding “principle” of most people is “people should do what I want and not do what I do not want them to do.” So, people tend to favor many laws against what they dislike and many laws for what they like. They tend to be against laws that are for what they are against and against what they are for.”

For businesses an environment of “do not see do not say” with limited business laws is considered the best. policies of “easy business” are widespread:

“Jun 1, 2010
Cameron announces his initiative for change. Picture: Andrew Yates/Getty
In his first speech as Prime Minister, David Cameron promised to aid companies by cutting red tape, improving the speed of business start-ups and kick starting bank lending.”

Cameron’s speech reflected the plans for businesses laid out in a new document, which was released last week in partnership with the Liberal Democrats.
In the document, the coalition government promised to introduce a one-in-one-out rule, whereby no piece of new regulation would be introduced without the exit of another. It also stated it would find a practical method of making small business rate relief automatic and would aim to level the playing field between small and large retailers, by enabling local councils to take into account competition laws whilst drawing up plans to shape new retail development.
The government added it would make the UK one of the fastest countries in the world to set up a new business and would end the ‘gold-plating’ of EU rules, so that British companies would no longer be at a disadvantage against their EU competitors.”

Any experienced business attorney could confirm countless stories of corporate management getting away with fraud by not paying on contracts. Number of schemas of how to trick the system and avoid legal actions is developed in details. Corporate limited liability laws are craftily exploited and are examples of this philosophy; e.g., countless fake offers on the Internet, through Junk mail or even on TV are coming from happy “honest” executives and advertisers with offers for easy money and immanent success if we buy their product, follow their advice or give them some money in advance. There are some laws that try to curb on such activities of fake advertising and canning promotions, but these laws are so difficult to win in court unless multiple fraud is not resulted in serious financial harm. However, preventive actions against possible fraud are very rarely taken. Moreover, the biggest harm for the economy does not come from pyramids and financial fraud but from the general “insecurity” resulted of such lawlessness. When in the past “easy business” could have been positive to boost pro-supply economies, which have already changed into pro-demand economies of a global marketplace. Hence, financing has been changing too: the narrowing profit margins of the US businesses have Large Capital well gone oversees particularly to China and now India even in case SMB have rarely been financed by large investors anyway, the ones left were the Small and Medium Investors who were the heaviest hit by the last recession.

“What Does Venture Capital Mean?
Money provided by investors to startup firms and small businesses with perceived long-term growth potential. This is a very important source of funding for startups that do not have access to capital markets. It typically entails high risk for the investor, but it has the potential for above-average returns.

Investopedia explains Venture Capital
Venture capital can also include managerial and technical expertise. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies or ventures with limited operating history, which cannot raise funds by issuing debt. The downside for entrepreneurs is that venture capitalists usually get a say in company decisions, in addition to a portion of the equity.”

In a pro-supply economy experiencing growth in a local marketplace (before the globalization took over) the system of deregulation and clueless business laws might have worked well. However, the situation in the world has changed greatly to a pro-demand open globalized marketplace, whereas the relative insecurity of small and medium businesses because of lacking clarity of business laws started having a negative market effect of: Insecure contracting, bonding and limited personal liability of corporate structures consequences of underwriting financing difficulties.

Usual for SMB are
- Limited access to public financing;
- Limited access to foreign markets experiencing economic growth;
- Limited ability to outsource production or move some production to somewhere more advantageous

Therefore, the necessity of stable borrow-ability in volatile economic environment or in direct competition to foreign companies, subsidized by their governments, is paramount. For SMB to be competitive would be only if better access to financing is available.

The overall condition of small and medium businesses and their profitability directly reflects the overall conditions of ones economy because SMB provide the highest percentage employment of all, thus if SMB struggle to survive as it happened through the 2007 Great Recession so the middle class and the poor in the US economy overall.

In an environment of globalization with open borders for business and ever-rising productivity, the large global corporations are not anymore interested in maintaining industrial production on US territory. Neither are they interested in investing into long term projects on US territory, because of the less expensive labor and well ongoing economic growth of China, India, Vietnam and etc.
It is with the large investors who really are not coming back on the US market; because of the lower ROI, therefore it is up to the small and medium businesses to create employment. The clarity of business laws bringing out higher security to SMB and SMI is from great importance to revive US economy and to funnel so needed wealth distribution and redistribution for balancing demand-to-supply ratios.

Small and medium businesses are much more flexible then large global corporations; SMB could develop in very diverse areas of business and reflect governments’ environmental policies much faster.

Many thanks for your comments on my discussion paper. I will answer your questions with pleasure.

In the main part, you ask me about the innovation of my experimental approach. Besides, you want to know why I do not use two-member teams with two decision makers,
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...but teams with one active and one passive member.

These questions are interrelated.

As you write, there are many papers concerned with team decision making. I also know and quote them (p. 4), and I agree with you that there is not much difference between Ultimatum and Stackelberg games: If players behave according to the subgame-perfect Nash equilibrium prediction, they receive asymmetric payoffs. In other words, firms are predicted to end up with asymmetric profits. That is the essential thing here and the crucial difference to Prisoner’s Dilemma or Cournot games. Therefore, I review Ultimatum and Stackelberg experiments (pp. 3-4). I concentrate on Stackelberg experiments because Stackelberg games directly stem from IO. They are part and parcel of every textbook on IO.

Since we know from experimental economics that individuals do not behave according to an asymmetric subgame-perfect Nash equilibrium prediction, the question is what causes the deviation from the prediction. An explanation is other-regarding preferences, another one is communication. In contrast to other experimental approaches, my experimental approach allows for the separation of these two effects. The only difference between NEUTRAL and TEAM is that the active participants in TEAM are given direct responsibility for the monetary payoff of someone else.

If the deviation from the prediction were caused by other-regarding preferences, TEAM decision makers should come closer to monetary payoff-maximizing behavior than NEUTRAL decision makers, because TEAM decision makers would not only consider their competitors’ monetary payoffs, but also their partners’ monetary payoffs. Because there is no other variation (like communication between two decision makers), my experimental approach allows for as much control as possible.

Another advantage is that my teams are organized according to Alchian and Demsetz’s contractual view of the firm. This is not an ad-hoc structure, but an established theory of the firm which is used in IO. Therefore, my experimental design falls within the domain of IO and allows for a test of IO. Whether an ad-hoc structured team falls within the domain of IO is questionable.

These two advantages make my experimental approach extremely interesting to me.

What can I say to your critical points 1 and 2?

1. You ask me whether the passive team members were bored and whether they were quiet. Actually, I do not know whether they were bored. However, I do know that they were quiet.

I really like your idea of using the strategy method in order to keep all participants busy. I decided not to use it because of the hot-cold empathy gap. If I had used it, there would have been no comparability between Huck et al.’s treatments and my treatments.

2. You feel that there are too few observations.

In all treatments, I applied Kamecke’s rotation random-matching protocol in order to obtain a perfect stranger matching. Because there were at least 24 active participants in each treatment and only 10 rounds, it worked completely fine. In my opinion, that makes at least 12 independent observations. I feel that this is enough.

Of course, you can never be sure about the absence of session effects. However, if I followed your advice of running 5 sessions, I would need 440 subjects to participate in the experiment.

Thank you very much for your report. I will answer your questions with pleasure.

What can I say to your critical points 1, 2, and 3?

1. I did not drop the STACKRAND treatment from the beginning, because I thought an intense discussion was
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...helpful. In view of your representation, I also think that it can be dropped from the start without losing precision.

2. As you mention, framing is problematic for several reasons.

Here, my point is that framing means introducing a specific auxiliary hypothesis in order to bridge the gap between the behavior of individuals and multi-person firms. It is the implicit assumption that individuals and multi-person firms show the same behavior. However, this auxiliary hypothesis is not confirmed (see also Albert and Hildenbrand, 2012, pp. 17-19). Therefore, theories of the multi-person firm cannot be tested in single-person experiments.

Another point is that loaded instructions may affect different participants differently. I do not know an ideal solution to that problem. Therefore, I prefer neutral instructions.

3. I totally agree with you that there is an infinite number of organizational structures. My experimental approach is just one simple approach for testing theories of the firms in the laboratory using the contractual view of the firm. However, the simple organizational structure brings decision making in a Stackelberg experiment more into line with profit maximization than the usual framing. Whether this is due to in-group effects or whether the contract structure makes people more selfish is indeed an open question.

More about this can be learned from further experiments, for example, where there are conflicts within the teams.

I totally agree with you that a Stackelberg experiment with individuals is rather a test of individual decision making than a test of IO, because IO is concerned with organizational decision making. That is why I use the
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...TEAM treatment.

My teams are organized according to Alchian and Demsetz’s (1972) contractual view of the firm in order to bridge the gap between individual and organizational decision making. Alchian and Demsetz’s structure is an established theory of the firm which is used in IO. The experimental design therefore allows for a test of IO. This is the crucial point.

I really like your idea of analyzing the general importance of framing effects. However, this is a suggestion for another paper.

You ask me whether there is a literature on the effects of the size of the earnings relative to the show-up fee. Actually, if there is such a literature, I do not know it. I only know the general literature on the effects of the size of the earnings (see, e.g., Smith and Walker 1993; Goeree and Holt 2001).